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Intertemporal Macro Notes
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Intertemporal Macro Revision
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INTERTEMPORAL MACRO 'Macroeconomics' Carlin & Soskice 2006 CHAPTER 7
Consumption o Introducing intertemporal smoothing in consumption behaviour
Consumer expenditure makes up about one half of total final expenditure on goods and services in the economy
Keynesian consumption function:
Constant autonomous consumption, means we expect 2 things: o Aggregate consumption is volatile because any change in current income is reflected in a change in consumption in the Keynesian consumption function o Should be no difference between effect on consumption of transitory changes in personal income and permanent changes.
These predictions seem too extreme. Why?
o Consumer preferences o Ability of people to look ahead and form a view about their future income prospects o Ability of people to borrow
Alternative views take the above into account e.g. PIH/LCH o 'suggested that consumption was a function not of measured income as in the Keynesian consumption function but of average or expected income or of the value of lifetime resources.' o 'the law student will have a much clearer idea of his earnings over the years ahead and the law student is more likely to be able to borrow to sustain higher current consumption.'
PIH and LCH o Both emphasise firstly the use of saving and dissaving to smooth consumption and secondly the unresponsiveness of consumption to income changes that were perceived to be transitory. o LCH model begins from insight that income will follow a reasonably predictable pattern over most people's lives - borrow when they're young, save when middle aged for retirement. o PIH model - what counts for level of consumption is not the income we earn at any one moment, but, rather the average income we expect to be earning in any time period.
i.e. it is the average expected income that truly determines the resources we have available for consumption - average income is permanent income
e.g. recession - if income falls PIH would predict no change in consumption unless people's expectations of ongoing future income have fallen as well o LCH produces qualitatively similar results to the PIH o With standard Keynesian consumption function, a deficit funded increase in G has a bigger effect on output than does the same increase in spending financed by higher T
PIH suggests this might not occur
If government sells bonds to finance G, bonds will have to be paid pack in the future (increase taxes) -> permanent income falls where taxes decreased today or in the future - Ricardian equivalence
If Ricardian equivalence holds, then the remedy for a recession that government should cut taxes will
not work - private savings will rise to exactly match the fall in government savings
Ricardian equivalence in IS:
o Consumer preferences, income and interest rates
Assume households live for two periods only and enter and leave the world with no wealth
FIGURE 7.1 (a)
IC's convex to origin - reflects the preference for smooth consumption over the lifetime i.e. equally happy at C and D on U 1 (high consumption in one period and low in another), but at E the utility is higher on U 2
Labour income in each period is y 1 and y 2 and consumption in each period is c1 and c2, real IR is r.
If wealth is zero at start and finish, value today of lifetime consumption must = value today of lifetime income
Intertemporal budget constraint: o o Present value of lifetime consumption = present value of lifetime income FIGURE 7.1 (c) see above
Slope of budget constraint is -(1+r) Maximises utility at F FIGURE 7.2 (a) shows implication of a rise in income in the first period only. o Outward shift of budget constraint, IR not changed so budget constraint moves parallel. o If change in income is in the second period but not the first, but is known about in the first period, same effects. PIH - timing does not matter. FIGURE 7.2 (b)
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